Small-Cap Stocks Have Multiple Tailwinds | ETF Trends

The small-cap Russell 2000 Index is beating the S&P 500 by 250 basis points year-to-date, and that could be the start of something more substantial, as plenty of market observers believe that multiple factors are in place for 2023 small-cap upside.

A slew of exchange traded funds stand to benefit from small-cap bullishness, including the WisdomTree U.S. SmallCap Fund (EES). To be precise, EES isn’t just getting in on the small-cap act early in 2023. The WisdomTree ETF is showing leadership, topping both the Russell 2000 and the S&P SmallCap 600 Index by notable margins.

The earnings-based methodology that EES adheres to is important in any environment, but even more so today because small-cap stocks are seen as deeply discounted relative to their potential earnings potency.

“In early 2021, the price-to-earnings (P/E) and forward P/E ratios (both excluding negative earners) of the small-cap core, value and growth markets peaked, with most rising comfortably above their long-term averages. Since then, valuations have compressed, with both measures across all three investment styles remaining about two standard deviations below their long-term averages,” noted WisdomTree’s Brian Manby.

Add to that, small-caps are forecast to generate more earnings growth this year than large-caps, which is meaningful to EES because that’s a scenario in which the fund’s strategy can shine. Not to mention the point that some broader small-cap benchmarks are chock full of companies that aren’t profitable — a trait that might not be in style this year.

Speaking of valuations, the allure of EES is enhanced by the fact that investors don’t have to pay up to access the benefits offered by this ETF.

“Valuations relative to both large and mid-caps have consistently remained more than two standard deviations below their long-term averages since the second half of 2021 as well,” added Manby. “This was primarily due to the economic uncertainty and impending rate hike cycle that markets were forced to confront after the rapid, post-pandemic recovery. Investors who bravely maintained their equity allocations preferred the perceived safety of larger companies at the expense of smaller ones, and the small-cap market suffered disproportionately.”

The $709.68 million EES could prove durable in the current climate, and its emphasis on profitability provides investors with a valid, potentially long-term approach to small-cap equities.

EES “may withstand market volatility due to its explicit focus on profitable companies while avoiding non-earners. If the historical relationship between multiples when excluding unprofitable companies and outperformance versus large caps is any indicator, EES could be well-positioned for small-cap allocations during an equity market recovery,” concluded Manby.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.